Now that 10-year Treasury yields have reached levels not seen since 2011, markets are searching for clues about what will happen next. Absolute levels for rates are hard to predict, but their direction and relative levels can be evaluated through a variety of historical relationships. For example, on a long-term trend basis the average yield on the 10-year Treasury note is approximately 140 to 220 basis points below nominal GDP growth. To set an upper bound on this calculation, if GDP growth were 4 percent and inflation 2.5 percent—definitely the high end of our estimates—and subtract 200 basis points, then we would expect to see a 4.5 percent 10-year yield. I don’t think we are going to get to 4.5 percent, but sometimes ruling out the ludicrous is useful.
This upper bound is ludicrous because the yield curve typically inverts at the end of the tightening cycle. If we did see 4.5 percent on the 10-year note, then that would mean the end-of-cycle short-term rate would also have to go to the unlikely level of 4.5 percent. Not only would many corporate borrowers not be able to service their debt at these levels, but other markets in the world would be dramatically affected and emerging markets would get crushed. Moreover, growth in the 4 percent area would push GDP growth well above potential, which is a classic end-of-cycle sign that usually marks the top in Treasury yields and leads to recession.
At Guggenheim, our work suggests that the real upper bound on long rates is close to 3.5 percent, and if it did get there, it would probably be short-lived. As I have been saying for a while, the Federal Reserve (Fed) will raise rates four times this year, and probably four times next year before stopping. After the June meeting, the Fed’s overnight target range for fed funds is between 1.75–2.00 percent, meaning at year-end it will be 2.25–2.50 percent, and a year later it will be between 3.25–3.5 percent. Given this terminal rate, it is unlikely for the 10-year yield to go above 3.50 percent.
The possibility also exists that 10-year rates could go lower from here, based on a number of looming exogenous factors. One of the biggest factors coming into play is what we are starting to see overseas. In Italy, the anti-euro Five-Star Movement and the League have formed a government, which is setting off a bit of a panic that is causing Italian government bond yields to skyrocket. The growing concern around the survival of Europe is likely to make U.S. Treasury securities look more attractive to foreigners.
We also are seeing creaking in the emerging markets. Argentina has had a massive currency devaluation and local interest rates have risen sharply as the central bank tries to defend the currency. Turkey is going through a similar stress episode. Having lived through this sort of thing before, I know they do not end well. These sorts of events do not remain isolated, but usually spread like contagion. Argentina’s actions will put pressure on its neighbors and its trading partners. We are already seeing signs of pressure in Brazil and Chile as these emerging markets have fallen significantly from recent highs.
The Federal Reserve is not going to stop raising rates based on any of these exogenous factors, as long as they do not have an impact on the U.S. economy. Just like in the Asian financial crisis, it will have to take notice if the problem spreads. When Thailand devalued the baht in July 1997, it was another year before the contagion hit our shores. The cascade started when the Thai baht lost 50 percent of its value, giving Thailand a competitive advantage in manufacturing and exports. Local assets also got much cheaper for foreign investors. Economic activity and capital moved to Thailand, which slowed neighboring economies. Ultimately the regional currencies fell like dominos as neighboring economies began to slow. Finally, in September 1998, the Federal Reserve aborted its tightening and reversed course to avoid a global financial collapse.
Seemingly small one-off events, like the troubles in Argentina or the anxiety in Europe, do not appear to bear any relevance in the short run, but they can turn into massive global storms which could force the hand of the Fed to abort its current tightening.
For investors, the next steps are clear. In rates, short duration and floating rate assets will benefit as the Fed continues to raise rates, Libor follows suit, and the short end of the curve rises. At the same time, long duration assets likely have less downside risk. This situation calls for a duration barbell. In credit, spreads are likely to widen from here, perhaps due to these exogenous factors or, ultimately, because of recession.
Markets should prepare for a collision course with disaster: Over the course of the next two years the effects of fiscal stimulus will wear off and monetary policy will get more restrictive.
Now, as newly installed Fe employment and a sharp decline in profitability, followed by widening credit spreads as the market discounts the expectation of higher corporate defaults.
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